Seagate: Significantly Overpriced Relative To Historical Standards – 20%+ Downside (STX)

Recently the memory companies Western Digital Corporation (WDC) and Seagate Technology Holdings plc (NASDAQ:STX) came out with earnings and I decided to take a look at both companies, curious to see what kind of value proposition they made. After reviewing the earnings calls and relevant financial information, I concluded Seagate’s valuation was out of skew with the realities of their industry and the performance of the company itself over the past 20 years. I examined two sections of one decade each and took a look at what the various yield metrics were, ideally to have an idea of how the firm was viewed on a risk level. The company is cyclical and has been around for a while, so it is easier to see how the metrics of yield stack up. Today? Not too good.

Background

“Seagate Technology Holdings is a leading provider of data storage technology and infrastructure solutions. Its principal products are hard disk drives, commonly referred to as disk drives, hard drives, or HDDs.

HDDs are devices that store digitally encoded data on rapidly rotating disks with magnetic surfaces. HDDs continue to be the primary medium of mass data storage due to their performance attributes, reliability, high capacities, superior quality, and cost-effectiveness. Complementing HDD storage architectures, SSDs use NAND flash memory integrated circuit assemblies to store data.

The Company’s HDD products are designed for mass capacity storage and legacy markets. Mass capacity storage involves well-established use cases, such as hyperscale data centers and public clouds as well as emerging use cases”. (Source: SEC 10-Q).

HDD has been the storage standard for decades. However, in recent years, the advent of enterprise-level flash memory, its decreasing costs, storage capabilities, efficiencies, and sustainability have eroded this standard.

Industry Background

I am not going to go into significant detail on the history of HDDs, suffice it to say they have been the dominant form of memory storage. Seagate is a veteran in this industry. Today, most of their revenue is made selling on the enterprise or cloud level. RAID (Redundant Array of Independent Discs) started 35 or so years ago and allowed multiple hard drives to be connected for what became data centers. Cloud storage is about 20 years old, but again demand for large-scale storage caused demand for HDDs.

This industry is mature and currently acts as an oligopoly. There are a few major players. This is after years of competition and consolidation. However, new technologies have forced HDDs to become more niche.

Around 10 years ago, SSD (solid state drives) began to become more relevant for cloud and enterprise-level storage. This was due to declining prices and improving technology. This is an ongoing thematic for the industry. The cost per gigabyte has continued to decline, making them ubiquitous in consumer storage technology currently. This is a critical point to consider when evaluating a company that generates almost their entire revenue stream from HDDs.

Financial Information and Valuation

I am going to give you some historical financial information for STX, showing how profitable their business has been. The company was private for a while and I don’t have easy access to the old information, but I will present two decades. One will be from 2003-2013, and the other from 2014-2023. The fiscal year for the company ends in June. I’m presenting this as charts. This is all my own work based on SEC data.

EBITDA yield (Author)

After reviewing the above charts representing 2003-2013, we can make a few conclusions:

• The free cash flow to enterprise value was cyclical and averaged 10%.
• The EBITDA to enterprise value averaged 16%.
• The operating income to enterprise value averaged 7%.
• The revenue while cyclical moved higher over the period.
• The peak year for free cash flow was 2012 with 2.6 billion. The enterprise value started the fiscal year at 5 billion and ending at 11 billion.

From the looks of it, Seagate was generating nice returns relative to EV over this period. Now consider the next decade 2014-2023 in the following charts.

Initial Conclusions

Here are a few conclusions we can draw from the period of 2014-2023.

• EBITDA to Enterprise value mean is 11% or 31% lower than the previous decade.
• Operating income to Enterprise value mean is 7%, about the same as the previous decade.
• Free Cash flow to Enterprise Value mean is 8%. around 20% lower.
• Revenue relatively has been going lower. Its mean non-inflation adjusted revenue is about the same as the previous decade.
• Mostly downward sloping charts and current lower than mean.
• The peak free cash flow year was 2014 with 2 billion. The enterprise value started the year at 16 billion ending at 20 billion.

It appears that the peak year in the previous decade generated more free cash flow and was cheaper relative to the more recent decade. I don’t see a justification for this as interest rates were actually lower than they are today.

Perhaps as a whole the company is a stronger company in the current decade and maybe that justifies the value difference. It’s the opposite. The average common tangible equity for the previous decade was 2.24 billion. For the most recent decade, it is 1 billion. More specifically, as of the most recent quarter, the common tangible equity is -2.9 billion. That to me would be a negative.

Regarding the FCF/EV value, I did an analysis of the relationship between this value and the performance of enterprise value from Dec to June from 2004-2023. The relationship indicates that below .08 enterprise value had on average a -1.5 billion change over the period. Below .05 it decreased to -2.5 billion.

A TTM FCF number with an assumption of 100 mil cash flow next quarter gives you a rolling free cash flow total of 424 million. If you compare this against the current enterprise value of 24 Billion the FCF/EV number is .018.

Many people have discussed the cyclicality of the industry and that the company is just coming out of the bottom. Let’s examine both decades and see how they were valued at the worst point.

FY 2007 was the worst year in the older decade with 90 million free cash flow and an enterprise value starting at 13.4 and ending at 12.9 billion

We don’t have full data for the 2024 fiscal year, but it appears from a cash flow perspective this will mark the lowest cash flow year for the decade when they complete the fiscal year in June. This fiscal year they have generated 140 million in free cash flow and it is extremely unlikely in the next two quarters they make up for second place. We will call FY 2024 the bottom. The company had an 18 billion EV at the beginning of the fiscal year.

For a cyclical bottom, it appears that the equity is already overpriced. Midway through the fiscal year, the enterprise value has actually increased to 24 billion.

Let’s think about the difference in the metrics between what the company calls the bottom in the Sept Quarter of 2023 and the worst quarter of the worst fiscal year 2007. The older numbers are not inflation-adjusted. All figures in millions.

Click to enlarge

It appears STX was more expensive at the bottom of the 2014-2023 decade relative to 2003-2013.

In the past few days, Seagate released earnings. During the conference call, it was indicated that the bottom had been passed. Here are the numbers for the quarter.

Click to enlarge

Looking at the current enterprise value, it appears the market is anticipating some serious growth. Forecasting this growth, however, is challenging. Both Seagate and Western Digital are only forecasting out 1 quarter. The Seagate CEO has said incremental growth will occur and has a positive outlook. This makes sense as it appears the bottom of the cycle has passed. However, they are rolling out a new product that is still being qualified. Things are getting better and will return to some sort of normal when the enterprise and cloud buyers purchase the new product. When will this happen? It appears based on the conference calls between both companies that maybe calendar year 2025-2026 they will be running strongly. Who knows? That’s a risky bet. If one assumes the previous decade was better than the current decade why would you pay metrics 50% higher today? The market is pricing expected growth and execution to past levels and staying there. This seems ambitious considering the financial data and history.

The infrastructure replacement lifecycle has also changed. It used to be three years, but in recent years, it has increased to five. Some might consider the cycle was turning down before the pandemic. Then, with the low interest rate environment and people working from home, more demand for infrastructure caused a large spending spree. If that is true and it was artificial, the infrastructure refit might not happen as soon as expected. I’m not an expert, but 10 years ago, SSDs were not really in enterprise and cloud. The market changes quickly, relatively speaking, ten years is a technological generation. One should be compensated for this risk, which is large. Therefore, conservatively I believe Seagate could easily trade 20% cheaper and still not be cheap.

Risks:

The bullish case for the HDD players has centered around the growth of demand for memory. Data demand growth has been very strong in the past and has continued to grow. Analyst firm IDC estimates that global data demand will grow at a 21% compound growth rate through 2026 (The Future of Data Center Storage – Horizon).

IDC also estimates that Worldwide Enterprise External OEM Storage Systems Market Spending will grow at 3% over the next five years. (IDC – Enterprise Storage Systems Market Insights). This is an interesting dynamic. Yes, there is growth in data demand, but it appears the spending is not anticipated to be growing at the same pace. A reason for this is that data is getting cheaper. We’ve had tremendous growth in data demand over the past decade yet Seagate did not see the same thing happen with their revenue. The direct impact of this growth on the company is not clear. Another consideration is the structure of the storage. HDD media is not absorbing the growth. SSD, Optical, Tape, and NVM are taking, and anticipated to take this growth.

Yes, the demand will grow, but look at the structure. If you look at the chart above, HDD byte shipments have grown by 5x since 2010, and Seagate’s revenue went down. Another concern is whether in ten years, hard drives will be leaning towards obsolescence.

Conclusion

At this stage and at this price relative to the previous decade and considering the dynamics of the memory sector, anyone purchasing Seagate here is assuming a significant risk and gambling on demand that isn’t guaranteed by any means. As shown above, normal cyclicality is already priced to an extreme. The price factors in growth much more than cyclicality here, and the growth trajectory is not evident. Even if they return to 2021 numbers for sales which were artificially based on interest rates, stimulus, and environment, it’s expensive. Not to mention they issued a convertible bond that has a conversion price of 82 and converts to around 18 million shares, (non-convertible until 2028). This could provide some selling pressure immediately as the owners will hedge their portfolio which involves shorting the underlying equity. The stock just recently went through the conversion price of 82.

Timing is challenging, but any sale here in 6 months’ time will be rewarded, in my opinion. One could enter a put spread the June 90/70 is around $5.